The ADP and ACP tests are the two annual nondiscrimination checks every traditional 401(k) plan must pass to keep its tax-qualified status. Both compare what highly compensated employees put into the plan against what everyone else puts in, and both carry hard correction deadlines. Miss them and the employer owes a 10% excise tax; ignore the failure long enough and the plan can lose its qualified status entirely.
What Each Test Measures
The Actual Deferral Percentage (ADP) test looks at elective deferrals, meaning the money employees voluntarily direct from their paychecks into the plan, whether pre-tax or Roth. It operates under Internal Revenue Code Section 401(k)(3) and focuses only on what workers themselves choose to save. Every eligible employee counts, including those contributing nothing, which pulls the group average down when rank-and-file participation is thin.1Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
The Actual Contribution Percentage (ACP) test, governed by Section 401(m)(2), covers a different bucket: employer matching contributions and any after-tax employee contributions that don’t qualify for traditional tax-deferred treatment. Between the two tests, the IRS sees the full flow of plan dollars from both the employee and employer side.2Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans – Section: Nondiscrimination Test for Matching Contributions
Who Counts as a Highly Compensated Employee
The IRS splits the workforce into two groups. A highly compensated employee (HCE) is anyone who owned more than 5% of the business at any point during the current or prior year, or anyone whose compensation from the employer exceeded a set dollar threshold during the prior year.3Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year
For the 2026 plan year, that threshold is $160,000. Anyone who earned more than $160,000 in 2025 is classified as an HCE for 2026 testing. The figure adjusts periodically for inflation.4Internal Revenue Service. Notice 2025-67 – 2026 Amounts Relating to Retirement Plans and IRAs
Employers can also make a top-paid group election, which tightens the HCE pool. Under this election, employees over the compensation threshold count as HCEs only if they also ranked in the top 20% of earners at the company during the prior year. The 5% ownership test still applies either way. For companies with a lot of moderately well-paid workers, this election can meaningfully shrink the HCE count and make the tests easier to pass.
Everyone else is a non-highly compensated employee (NHCE). New hires with no prior-year compensation at the company are automatically NHCEs for that plan year regardless of their current salary, a detail plan administrators sometimes overlook.
How the Pass/Fail Math Works
Each test calculates a deferral or contribution percentage for every eligible employee, then averages those percentages within each group. The plan passes if the HCE average stays close enough to the NHCE average under one of two formulas.
The 1.25 Test
The HCE group’s average cannot exceed 125% of the NHCE group’s average. If NHCEs average a 4% deferral rate, HCEs are capped at 5%.1Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
The 2/2x Alternative
If the plan fails the 1.25 test, it can still pass under this alternative. The HCE average can be the lesser of two figures: the NHCE average plus 2 percentage points, or twice the NHCE average. At low NHCE averages, the “times 2” limit is tighter; at higher averages, the “plus 2” limit takes over. If NHCEs average 1%, HCEs can go up to 2% (twice 1%), not 3%. If NHCEs average 6%, HCEs are capped at 8% (6% plus 2), not 12%.
Non-participants get counted at 0%, which is where many plans stumble. Strong HCE participation paired with lukewarm rank-and-file enrollment lets those zeros drag the NHCE average down and tighten the HCE cap. That dynamic is a major reason employers push enrollment campaigns and automatic enrollment features.
Prior Year vs. Current Year Testing
Plans can use either the current plan year’s NHCE data or the prior plan year’s NHCE data to set the HCE limit. The prior year method gives employers early visibility into the cap because the NHCE average is already locked in before the plan year begins. Switching from current year to prior year testing is restricted: the plan must have used the current year method for at least the preceding five years, or fewer if the plan hasn’t existed that long.5eCFR. 26 CFR 1.401(k)-2 – ADP Test
Correcting a Failed Test
When a plan fails, the sponsor has two main correction paths. The choice usually comes down to cost, timing, and how badly the plan missed.
Corrective Distributions to HCEs
The most common fix is returning excess contributions to the HCEs whose deferrals pushed the plan over the limit. The plan works through the highest-contributing HCEs first, refunding just enough to bring the group back into compliance. These refunds must include any investment earnings attributable to the excess through the end of the plan year.6Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
Employer Contributions to NHCEs
Instead of taking money away from HCEs, the employer can bring the NHCE average up by making qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to NHCE accounts. These contributions come entirely from the employer, must vest immediately, and are subject to the same withdrawal restrictions as regular elective deferrals. This approach costs the employer more upfront but avoids telling executives their retirement savings are being sent back.6Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
Deadlines and the Excise Tax
Corrective distributions must be completed within 2½ months after the end of the plan year to avoid a 10% excise tax on the excess amounts. For a calendar-year plan, that is March 15. Plans using an eligible automatic contribution arrangement (EACA) get a longer window of six months after the plan year ends, or June 30 for calendar-year plans.7Office of the Law Revision Counsel. 26 USC 4979 – Tax on Certain Excess Contributions
Miss that window and the employer owes the 10% excise tax under IRC Section 4979. The plan can still correct by distributing the excess within 12 months after the plan year ends, but the excise tax applies regardless. Let the 12-month deadline pass without correcting, and the plan risks losing its qualified status. If disqualification actually happens, every participant gets taxed on the value of their vested benefits, employer contributions lose their tax deduction, and future earnings in the plan are no longer tax-sheltered.
Tax Consequences for HCEs Who Receive Refunds
When an HCE receives a corrective distribution, the excess deferral amount is taxable income. For pre-tax deferrals distributed on time, the amount is included in the HCE’s taxable income for the year the distribution is received, and the earnings portion is taxable in that same year.8Internal Revenue Service. Consequences to a Participant Who Makes Excess Deferrals to a 401(k) Plan
If the corrective distribution is not made timely, the excess gets taxed in the year it was contributed and taxed again when it is eventually distributed. Genuine double taxation. Filing an extension on a personal tax return does not extend the April 15 deadline for excess deferral corrections.
Safe Harbor Plans: Skipping the Tests Entirely
The most effective way to avoid ADP and ACP problems is to adopt a safe harbor 401(k) design. Under a safe harbor plan, the employer commits to a specific contribution formula in exchange for automatic exemption from both nondiscrimination tests.6Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
Three formulas are common:
- A nonelective contribution of at least 3% of each eligible employee’s compensation, paid whether or not the employee saves anything.
- A basic match of 100% on the first 3% deferred plus 50% on the next 2%. An alternative version matches 100% of the first 4% deferred.
- A QACA match, used with a qualified automatic contribution arrangement, that maxes out at 3.5% of compensation and is paired with automatic enrollment starting between 3% and 10% of pay with annual escalation.
Traditional safe harbor contributions must vest immediately. QACA safe harbor contributions can use a two-year cliff vesting schedule, meaning employees forfeit the employer contributions if they leave before completing two years of service.9Internal Revenue Service. Issue Snapshot – Vesting Schedules for Matching Contributions
The trade-off is cost certainty versus testing risk. A safe harbor employer knows exactly what it will spend on contributions each year. A traditional plan employer might spend less, or might spend just as much on QNECs after a failed test, with the added hassle of corrections and excise tax exposure. For companies that routinely fail or barely pass ADP/ACP testing, converting to safe harbor is usually the better move.
Fixing a Failure After the 12-Month Window
Missing the 12-month correction window does not automatically mean disqualification. The IRS Employee Plans Compliance Resolution System (EPCRS) offers a path to fix errors after the standard deadlines.
Under the Self-Correction Program (SCP), an ADP or ACP failure can be substantially corrected if the employer acts before the end of the third plan year following the year that includes the last day of the normal correction period. Insignificant operational errors can be self-corrected at any time with no deadline. Failures that don’t fit either category require the Voluntary Correction Program (VCP), which involves a formal submission to the IRS and a compliance fee.10Internal Revenue Service. Correcting Plan Errors – Self-Correction Program (SCP)
Both late correction methods require the employer to make qualified nonelective contributions to NHCE accounts. Corrective distributions to HCEs alone won’t satisfy the IRS once the 12-month window closes. The employer contribution requirement is effectively the penalty for being late, shifting the cost from HCEs back onto the company.6Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests